With crude oil prices rising to levels not seen in 10 months, energy stocks are witnessing some renewed interest. Fossil fuels are expected to play a key role in the energy mix as the world transitions to renewable energy sources, in turn enabling top oil and gas companies to continue generating value for their shareholders.
Energy stocks could be a good long-term investment if selected judiciously. On the other hand, wrong investments can burn a big hole in your pocket. If you are new to the energy sector, here are three common mistakes to avoid, so that you don't end up losing your hard-earned money.
1. Selecting stocks solely on yields
The lure of high dividend yields is difficult to avoid. Who doesn't like double-digit interest-like steady income? However, history shows that basing decisions solely on highest yields could prove disastrous. Not only do you stand to face a dividend cut, but you may also lose significant invested capital.
Consider the example of Energy Transfer (NYSE:ET). The master limited partnership is trading at a distribution (dividends that MLPs pay) yield of nearly 15%.
But that doesn't make it a buy. The company has a long history of aggressive leverage and poor governance. That forced it to slash its payouts in half last quarter. Additionally, the stock is down nearly 80% since 2015. Not only has the investors' distribution income been cut to half, but those who entered into the stock in 2015 also face significant capital loss. In comparison, Enbridge (NYSE:ENB) provides attractive yield with much lower risks.
If you see a remarkably high yield on an energy stock, there's almost always a good reason. This is not to say that you should avoid all high-yield stocks. At times, especially during market volatility, some fundamentally strong stocks could sell at high yields. But be judicious and do research before deciding which one to buy.
2. Speculating on oil prices
Another mistake that energy investors often make is trying to predict oil prices and making purchase decisions based on their predictions. Investors hope to make quick profits using this method, but often end up with losses because oil prices are inherently volatile. There are numerous moving pieces that affect oil prices. These include, but are not limited to, changes in demand and supply, changes in inventory levels, exploration and production expenditures by companies, and actions from the Organization of Petroleum Exporting Countries (OPEC).
Though formed with an objective to promote stability in oil markets, OPEC hasn't been very successful in achieving its goal. Its member and partner countries have failed to agree on production cuts, or were non-compliant on agreed cuts, numerous times in the past. This adds lots of volatility in oil prices.
Though higher oil prices mean increased profits, especially for companies directly involved in production, predicting oil prices is a nearly impossible feat. It makes a lot of sense to invest in companies that can do well even when commodity prices are low. Midstream companies, that provide infrastructure to store, transport, and process oil and gas, tend to generate more stable cash flows compared to oil and gas producers. Enterprise Products Partners (NYSE:EPD) and Enbridge are two such companies resilient to commodity price volatility. With an impressive track record of distribution growth combined with a healthy growth outlook, Enbridge looks attractive, especially for income investors.
3. Investing for the short term
If you anticipate a need to liquidate your position within a year or two, energy stocks aren't an ideal investment option. As discussed above, oil and gas prices could be very volatile. These, in turn, drive energy stock prices. You may end up losing substantial capital if you are forced to sell a stock at a wrong time. For example, right now isn't the best time to sell your oil and gas stocks.
Most energy stocks, especially pipeline stocks, offer attractive dividend income. They make a good addition to your dividend portfolio. But you should invest in the energy sector with a long-term view to benefit from the yield returns. Several oil and gas companies are also focusing on renewable energy sources, keeping an eye on the longer-term trends in the sector.
BP (NYSE:BP) seems to be the most radical in its approach so far toward this transition. Total (NYSE:TOT), Chevron (NYSE:CVX), Enbridge, and others are all doing whatever they believe is best to become more environment-friendly.
While this is a welcome step, don't expect to see the results too soon. It may be years, or decades, before renewables become a material revenue source for these companies. Until then, oil and gas is what will drive these stocks. Invest accordingly.